What are Income Clubbing Provisions and Tax Implications?

What is income clubbing?

Clubbing of income is done to ensure taxpayers do not avoid paying their tax liabilities through moving of incomes of assets within the family. In general, a taxpayer is required to pay on his own income only but the tax department provides certain circumstances where the incomes in a family may be clubbed together and levied tax on.

What are the Rules of Clubbing of Income?

The clubbing of income concerns income from investments by you made on behalf of close relative such as minor child, spouse or daughter-in-law. These incomes are clubbed and you are ultimately taxed on the overall income. All investments including property, fixed deposits, shares, mutual funds and post office savings etc. are covered as clubbed income.

Clubbing of income is governed by Sections 60 to 64 of the Income Tax Act, 1961. The sections also states that income derived from assets that are directly or indirectly transferred in cases other than for due consideration to other people or associations that are likely to benefit the assessee’s spouse or daughter-in-law are also to be clubbed with the assessee’s earnings.

The following rules define clubbing of income:

Clubbing of Income in case of Minor Child (under 18 years):

Income from fixed deposit accounts made in the name of a minor child will be clubbed with that of the higher earning parent and taxes accordingly. In case of divorced parents, the one maintaining the child will be taxed.

Income of minor child’s when clubbed with your own will fetch you tax exemptions up to Rs.1,500 (subject to actual income) for each child.

Exceptions exist for income of disabled children as well as for minors who earn income from their talents, experience, knowledge or manual work.

Clubbing of Income in case of Spouse:

Income from investments made by you in the name of your spouse will be clubbed with your income and taxed accordingly.

Income from assets like properties in the name of your spouse when he/she hasn’t invested any money in buying the property will be clubbed with your income and taxed accordingly.

Clubbing of Income in case of Major Child (over 18 years):

Income from investments made by a major child will be taxed in the child’s hands only, even if the investments came from you.

Clubbing of Income of Daughter-in-law:

Income from assets transferred directly or indirectly to your daughter-in-law without any adequate consideration will be taxed after clubbing with your income.

Income from assets transferred to a person or association for instant or delayed benefit to your daughter-in-law without adequate consideration will be taxed on you after clubbing it with your income.

Ways to save Tax from Clubbing of Income:

There are different ways where you can save on some of the taxes when incomes are clubbed. You should however always be vigilant about new tax rules and not avoid taxes as the tax authorities provide stringent penalties on tax avoidance.

Interest on Interest:

In case you earn a lot of money while your Spouse has zero income, you can benefit from investments made in his/her name. The interest earned from the investment will be clubbed with your income and taxed accordingly. However, if your spouse re-invests the income and earns income from this investment, it will be taxed on him/her only as per respective tax brackets.

For instance, you have invested Rs.20 lakhs in equities in your spouse’s name and earn Rs.10 lakhs from that. The income from this investment will be clubbed with yours and taxed accordingly. However, if this Rs.10 lakhs is again invested by your spouse in equities and earns Rs.4 lakhs, the income this time will be taxed on him/her. So, assuming your wife doesn’t earn anything, this Rs.4 lakhs will put her in the 10% tax bracket with mandatory exemption up to Rs.2.5 lakhs. She will ultimately pay Rs.15,000 p.a. as income tax on the amount.

Now, if you had invested the Rs.20 lakhs in your name and reinvested the income of Rs.10 lakhs to make another Rs.4 lakhs, this amount will be taxed as per your tax bracket which is 30%. The amount of tax you pay is Rs.1.2 lakhs p.a. on this amount.

A point to note here is that if your spouse is in the 10% or 20% bracket, tax calculations will become complicated for you and you might not benefit from the investment also if your spouse is transferred to the 30% bracket with you if income from investments push her tax bracket. You should ideally approach this method only if your spouse or major child is not earning anything.

Loans to Child or Spouse:

Another way is to give money to your major child as interest-free loans. This is lawful and provides you with tax exemptions on up to an extent on the loaned amount. Giving loans to dependents will benefit you more than giving gifts. A simple letter notifying the loan amount and signed by both parties is enough to save taxes in this case.

Investing in name of Major Child:

The above mentioned interest on interest method could work for investments made in the name of a major child also. You could potentially benefit from the tax differential bracket again if the child does not earn or is in the lowest tax bracket.

Providing loans to a major child, as explained above, can also help you save on taxes.

You could also make investments in your minor child’s name which mature after the child reaches 18 years of age. In such cases the income arising from the investments will be taxed on your child’s respective tax bracket which will most likely be 0.

Investing in Exempted Instruments:

You can invest in your spouse’s or child’s name in tax saving instruments such as Public Provident Fund. Even income from mutual funds and shares held for over a year become tax free. In their names, the incomes would ensure no extra taxes on you.

Investing on would-be daughter-in-law or would-be wife’s name:

If you or your son is about to get married, then you could invest in the would-be spouse’s name. Income from such investments will not be clubbed with yours and will be taxed on them only. You can benefit in this case if the would-be spouse’s tax bracket is lower than yours.